1031 Construction Exchange
A build to suit 1031 exchange, a type of a 1031 construction exchange, is used to make improvements to the replacement property. An example of a 1031 construction exchange is the sale of the commercial property and replacing it with another improved commercial building. Proceeds from the sale of the old property go towards the build out allowing you to use some of your sale proceeds to improve the acquired replacement property as part of your 1031 Exchange transaction.
The proceeds from the sale of your relinquished property that are used toward the acquisition of your replacement property as well as those proceeds that are paid or used for improvements to your replacement property will qualify for tax deferred exchange treatment provided the transaction is structured properly as an Construction Exchange.
A construction or a build to suit exchange implies that the replacement property is acquired prior or after the old property is closed. Improvements to the new property are made with title conveyed to the taxpayer either on or before the 180th calendar day post initial closing. As long as the value of the improvements plus the cost of the replacement property is equal to or greater than the old property, the construction exchange allows taxpayers to defer the capital gains tax and recaptured depreciation triggered when the old or relinquished property was closed.
The Internal Revenue Service requires that an Exchange Accommodator Titleholder (EAT) created by your 1031 exchange company to park or take title to the property while it is being improved. The EAT is a single member limited liability company (smllc) with a non-related party to the taxpayer as member. Traditional exchange time lines of 180 calendar days apply to complete the build out. Near the end of the exchange or sooner, the improved property is deeded to the Exchangor or ownership of the smllc holding title can be transferred to the Exchangor. In states where transfer taxes are levied, transferring the smllc is a recognized strategy of avoiding the transfer tax. Planning is important given the deed must be titled to the Exchangor within 180 calendar days post closing of the new property. The relinquished property must also be sold by the 180th calendar day. Otherwise, the Exchangor will own two properties and the tax on the sale won’t be deferred.
Construction 1031 Exchanges are combined or used in conjunction with either a Forward Exchange or a Reverse Exchange structure. These are significantly more complicated 1031 Exchange transactions and should only be administered by a Qualified Intermediary that has significant experience and expertise handling Construction Exchanges.
Construction Exchange With a Forward 1031 Exchange
Forward 1031 Exchange transactions can be structured to take advantage of the Construction 1031 Exchange strategy. This combined 1031 Exchange strategy allows you to sell your relinquished property first and then subsequently identify and acquire replacement property as well as make improvements to your replacement property as part of your 1031 Exchange transaction.
The identification of the replacement property and the improvements to be made to the acquired replacement property, as well as the actual closing on the replacement property, must be performed and completed within the prescribed 1031 Exchange deadlines.
Construction Exchange with a Reverse 1031 Exchange
Reverse 1031 Exchange transactions can also be structured to take advantage of the Construction 1031 Exchange strategy. This combined Reverse and Construction 1031 Exchange strategy allows you to acquire your replacement property first and also improve the acquired replacement property during the time that you’re trying to sell your existing relinquished property.
The improvements that are to be made to the acquired replacement property, as well as the actual transfer of the replacement property with the completed improvements to you from the Exchange Accommodation Titleholder (see comments below), must be performed and completed in conjunction with the closing of the sale of your relinquished property within the prescribed 1031 Exchange deadlines.
No matter which combined strategy you choose, the Construction 1031 Exchange allows you to acquire your replacement property and use some of your 1031 Exchange funds to improve your acquired replacement property on a tax-deferred basis provided the proper parking structure has been put into place.
Parking Arrangement Pursuant to Revenue Procedure 2000-37
The replacement property cannot be acquired and held directly by you while the improvements or renovations to the property are being completed. Legal title to your replacement property must be acquired and held or “parked” by an Exchange Accommodation Titleholder in order to properly structure an Construction 1031 Exchange transaction and qualify for tax-deferred exchange treatment.
This “parking arrangement” is outlined and permitted pursuant to Revenue Procedure 2000-37. The Internal Revenue Service issued Rev. Proc. 2000-37 on September 15, 2000, which provides guidance on how to properly structure a Construction 1031 Exchange transaction by using a parking arrangement in conjunction with either a Forward 1031 Exchange or a Reverse 1031 Exchange.
The Parking Arrangement
You will enter into an agreement called the Qualified Exchange Accommodation Agreement or “QEAA” that will define and structure the parking arrangement to be used for your Construction Exchange transaction. The QEAA is entered into by and between you and Adelphi Retirement Management, LLC, as your Exchange Accommodation Titleholder or “EAT”.
The Exchange Accommodation Titleholder or “EAT” is (and always should be) a separate legal entity apart from the Qualified Intermediary. The EAT will purchase and hold or “park” legal title to your replacement property during your Construction 1031 Exchange transaction through a special purpose entity often referred to as an “SPE.”
Special Purpose Entity
Adelphi Retirement Management, LLC, which serves as your Exchange Accommodation Titleholder or “EAT”, will set-up a special purpose entity or “SPE” in the form of a single member limited liability company or SMLLC that will be used exclusively to acquire and hold or “park” title to your replacement property during your Construction 1031 Exchange.
The formation of this special purpose entity is crucial in order to protect you and your replacement property from liens, judgments and other legal problems stemming from other clients’ parked properties. The SPE ensures that your parked property will never be held in an entity that also holds other clients’ parked properties.
Construction 1031 Exchange Deadlines
Deadlines to complete your Construction Exchange are the same as a Forward 1031 Exchange or a Reverse 1031 Exchange transaction, depending on which structure you have chosen to combine with your Construction Exchange.
The 45 and 180 calendar day deadlines are the same. You have 45 calendar days to identify the appropriate property, again depending on which structure you have chosen, and you have an additional 135 calendar days — for a total of 180 calendar days — to complete your Construction 1031 Exchange transaction.
Construction Exchange Fees and Costs
Construction 1031 Exchanges are more complicated and costly structures, so you need to review the amount of depreciation recapture and capital gain income tax liabilities being deferred to ensure that the cost of the Construction 1031 Exchange transaction is justified.
With some planning call us at Adelphi Retirement Management, LLC, to discuss and explore how we can help you at 346.800.2882 and rest easier.
Wai-Yew Lam, President.
TREC Certified Instructor